The Insurance Hypothesis: An Examination of KPMG's Audit Clients around the Investigation and Settlement of the Tax Shelter Case

    Authors

    D. L. Brown; S. Z. Shu; B. S. Soo;G. M. Trompeter

    Comments

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    Abbreviated Journal Title

    Audit.-J. Pract. Theory

    Keywords

    insurance hypothesis; KPMG; tax shelter; LEGAL LIABILITY; FIRM TENURE; QUALITY; REPUTATION; MARKET; CREDIBILITY; IMPACT; FORECASTS; ACCRUALS; EARNINGS; Business, Finance

    Abstract

    Although prior literature has suggested that independent audits provide an implicit form of insurance against investor losses (the "insurance hypothesis"), it has been challenging to isolate the "insurance" effect. In this paper, we use a unique setting to examine this effect. In 2002, KPMG was investigated by the U.S. Department of Justice in relation to tax shelters sold by the firm. From then until early 2005, several news reports suggested that KPMG would be indicted and suffer potentially the same fate as Arthur Andersen. However, in August of 2005 KPMG entered into a deferred prosecution agreement with the U.S. Department of Justice, which ended widespread speculation of an impending federal indictment against the accounting firm. Because the investigation centered around tax services offered by the firm, we argue that the circumstances surrounding the investigation and settlement provide a natural setting to test the insurance value provided by auditors. We show that KPMG audit client firms experienced significant negative abnormal market returns when it appeared more likely that KPMG would face criminal charges, but earned significantly positive abnormal returns following news reports of an impending settlement. Further, these abnormal returns appear to be driven by KPMG client firms in greater financial distress or subject to greater litigation risk. These findings are consistent with the insurance hypothesis. Although we cannot completely eliminate other explanations such as an assurance effect or switching costs, we argue that such explanations are unlikely to drive our main findings.

    Journal Title

    Auditing-a Journal of Practice & Theory

    Volume

    32

    Issue/Number

    4

    Publication Date

    1-1-2013

    Document Type

    Article

    Language

    English

    First Page

    1

    Last Page

    24

    WOS Identifier

    WOS:000326346700001

    ISSN

    0278-0380

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